In this fast paced world and with ever evolving technology, there are some significant revolution happening globally, be it The AI revolution or the Green Energy Revolution. These companies look promising on the basis of their prospects and catch investor’s attention to deliver grandeur returns by reshaping and transforming society. Some other industries have caught investors’ imaginations were the radio, airline, automobile and the biotech industries. Every investor dream of creating massive wealth, which in turn caused a massive run-up in stock prices as the public goes mad pumping money into them. This takes stock prices much higher enticing other investors to invest and existing investors to invest more. This process continues until economic reality succumbs to the financial laws of gravity. At some point of time the bubble bursts and prices fall.
In USA alone, from 1919 to 1939, more than three hundred airline manufacturers came and went. Fewer than ten survive today. The internet massacre was equally sobering-hundreds of companies, some that once commanded $100 or more a share, have become nothing but bitter memories in the minds of their shareholders.
The problem with these transforming industries is that they seldom, if ever, establish any kind of durable competitive advantage due to intense competition that exists in the infancy of any industry. Intense competition means lower profit margins which hurts the soaring stock prices.
Due to lack of durability you should avoid investing in these emerging industries on prospects. Investors like Warren Buffet believe that if the entire company isn’t worth buying at the current stock market price, he shouldn’t even buy a single share. It is a unique way to look at a prospective investment.
To understand this approach you need to know how to calculate what is called the company’s stock market cap.
The market cap is computed by multiplying the number of shares outstanding by the current market price of one share of the company’s stock. Let’s say that Company X has 10 crore shares outstanding and is trading at INR 50 a share. The market cap for Company X would be INR 500 Crore.
Consider a case where you would have an option to invest between two companies: Yahoo, which was an emerging internet company in 2000 and on the other side Allstate which is an Insurance company with durable competitive advantage over its peers. You would had most likely bet on the Yahoo as it seems to give massive returns over next several years because of its society transforming prospects.
Allstate in 2000 had 749 million shares outstanding, which gave it a market cap of $13.4 billion (749 million shares * $18 a share in 2000). It earned approximately $ 2.2 billion a year. This means that if you spent $13.4 billion in buying in all of Allstate in 2000, so that you owned the entire company, you would have earned $2.2 billion in revenues, which equates to 16.4% a year on your money. This is a much better deal that you have gotten by paying $ 97 billion for Yahoo just to earn only $220 million, which equates to earning less than 1% a year on your money.
Conclusion:
Do not invest in emerging industries with lack of historical durable competitive advantage.
When considering to invest in a company, ask yourself following question: If the company in question had a market cap of INR 5 billion and I had INR 5 billion sitting in my bank account, would it be a use of my money to buy the whole company?
If the entire company isn’t worth purchasing at the current stock price, you shouldn’t buy even one share.
